This article continues the plan outlined in the previous article “Central banks as banks.” As I’ve described it here, this should become a chapter in my banking textbook. I will not describe private banking – because that is the subject of other chapters – but I will address the issues of interbank transactions. This article is about fundamental principles that we usually don’t think about.
As their name suggests, central banks are at the center of the banking system. The goal of a well-run banking system is that you don’t have to worry about how it works. As long as everything works under the hood, you don’t need to worry about how money moves from one account to another. By not worrying about these details, we tend to focus only on the flashy parts of central banking (e.g. trying to achieve an inflation target) instead of the regulation part of the banking system.
Peer-to-peer monetary exchange
We need to step back and ask ourselves: why banks? If we assume we have a cash economy, why not have a system in which individuals and businesses transfer “money” directly to each other without intermediaries?
For some people, this seems ideal: we have an economy in which people pay while handing over pieces of gold or transferring cryptocurrencies directly. However, for law-abiding citizens, this is not attractive: precious metals (and paper claims to protected gold) present a risk of theft, and making large transactions would not be attractive. (Popular media like the film Spartacus had the Romans conducting large commercial transactions with bags of gold coins; they had the economic equivalent of banks – as discussed in “The Monetary Systems of the Greeks and Romans” , by WV Harris.) suing to recover cryptocurrencies also renders them useless for large business transactions, and presents risks of lost passwords (or heirs not having access to a password).
Although economic theory suggests that everyone “wants to hold money,” in a sophisticated economy where there is trust among economic actors, people want intermediaries to hold most of the “money.” This means that most of the “money” ends up being a credit relationship.
An intermediary
The simplest possible intermediation system consists of having only one intermediary. Everyone would hold accounts with this intermediary, as well as bearer certificates (e.g. bank notes) convertible into claims on this intermediary.
This middleman will almost certainly look like a bank, and the only question is who owns it.
-
Foreigners: You have adopted a foreign currency. While this may be acceptable in some countries with poor inflation records, it will not be popular in countries accustomed to economic sovereignty.
-
The private sector. While this might please some free marketers, it is not a stable, long-term deal. This private monopolistic intermediary would obstruct the financing of the war, and as soon as an existential risk of war arises, this entity would be nationalized.
-
This could be a public central bank – in a system where there are no private banks. This is popular with some people, many of whom comment on my website. I am not in this camp, as I believe that a well-regulated banking system (integrated with non-bank financing) offers the least instability to capitalist finance. (Finance is inherently destabilizing, so all we can hope for is to contain the instability.)
Once these possibilities are excluded, we are left with a situation with multiple intermediaries.
Several intermediaries leading to central banks
If we have several intermediaries, we immediately run into a problem. What happens if the two parties to a commercial transaction use different intermediaries? (If they use the same intermediary, then the intermediary simply adjusts the two balances without requiring external transactions.)
We are left with intermediaries facing the same problem as law-abiding citizens: they must transfer the underlying “monetary asset” between them to allow transactions to pass through them. If “silver” is a precious metal, this means that there will be regular shipments of high-value metal, which poses a risk of theft.
The way to solve these problems is to have “senior” intermediaries who settle transactions for smaller ones. Customer transactions are cleared through a system of connected intermediaries. It is not necessary that there be a single “first-tier” intermediary, but we will now understand why developed countries have moved in this direction.
What is money?
We must now ask ourselves the question: what exactly do our monetary units correspond to? There are two cases.
-
Indexed currency. The monetary unit is linked to an external unit, either gold or a strong currency. (Or perhaps a hard currency tied to gold.) The value of the local currency is determined by the credibility of the peg, which usually requires holding collateral assets (or generating a sizable trade surplus that allows him to obtain credible support if necessary). While there is a convenience factor in having a central intermediary, it is not required.
-
Non-indexed currency. The monetary unit is the unit of account for a senior intermediary. Since this primary intermediary can create the unit of account at will, it will eventually become the “central bank”.
In the second case, the central issuer of the currency need not be a government, but it seems unlikely that it would be anything else. Historically, we had somewhat unruly companies like the Hudson’s Bay Company that could afford to issue tokens and maintain the value of those tokens, but that was only really possible because the company acted as A de facto government. Otherwise, only the most gullible members of the public would take unsecured private currency too seriously. (Although the cryptocurrency craze has shown that such people exist.) Meanwhile, the specter of war financing means that the government will sooner or later become the monopoly issuer of the (basic) unit of account (which brings us to standard MMT topics).
My interest and focus is on developed economies that have non-pegged currencies (the hard currency of the Euro being something of an exception). Even though the mechanics of a pegged and non-pegged currency may be superficially similar (for example, there was no major domestic shock in operating procedures when Nixon closed the gold window), the behavior of systems in the event of a crisis is radically different.
Wholesale payment systems
I will now end with some general comments on wholesale payment systems. (Retail payment systems – how consumers pay for things – are outside my area of interest.) A payment system allows its members (usually banks, but lobbyists are pushing for opening up to non-banks) to transmit large blocks of money to each other.
Each currency block has its own system, and there is also the question of the transmission of money to other currency blocks. Systems are complex and most discussions are directed at the handful of entities that interact with those systems. Given the differences between jurisdictions and my opinions on their economic impact, I will not attempt to delve further into the subject.
The key observation is that the payment system is intended to be a means of transmitting cash from entity A to entity B by the end of the day. Assuming everything goes well, all payments in and out of the payment system are void. As such, the balance sheet of the payment system is assumed to be effectively zero (beyond any infrastructure on its balance sheet).
The risk that everyone is worried about is that a major member goes bankrupt, and then payments might not be zero. Does anyone owe a member money? WHO? How is debt resolved? Since it is unclear what the bankruptcy judges will say, it is extremely likely that everyone involved will attempt to freeze the transactions, causing the system to collapse almost instantly.
Since it is clear that an undisturbed central bank would consider this a very bad outcome, the payments system would eventually be bailed out. In other words, the wholesale payments system is too important to fail – and should rightly be considered a contingent part of the central bank’s balance sheet.
This brings us to a simple (and standard) way of looking at interbank transactions: we assume that they are directly intermediated on the central bank’s balance sheet. If Bank A transfers money directly to Bank B, we believe that Bank A reduces its settlement balance with the central bank and Bank B increases its settlement balance.
It is not necessary for the balances to be positive during the day. If we take the Canadian system before 2020 as an example, the goal for end-of-day sales was $0. (This is the “simplified system of public finances” that I described in Understanding public finances.) That is, the bank starts with a $0 balance, sends and receives money based on customer orders (and its own transactions) during the day, and then the bank’s treasury office must bring the balance to $0 at the end of the day. the day (by carrying out a few wholesale transactions). Contrary to fairy tales spread by unreliable sources (mainly economics academics), banks do not wait for a positive balance before sending money: if everyone did that, the system would be frozen at the start day.
This system is extremely useful for clarifying thinking: banks trade “central bank balances” all day long, even though their net assets at the end of the day are assumed to be zero. In other words, we cannot look at balance sheet entries (which are at the end of the day) to infer anything about “transaction capacity”.
Reserves – largely an anachronism
One of the unfortunate side effects of American cultural imperialism is that the most popular economics textbooks were actually written by Americans. Central bank balances were called “reserves” for the very good reason that they contained almost entirely the required reserves. Banking regulations required banks to end the day with a target settlement balance, with this target based on the size of their deposit balances (based on obscure distinctions between deposit types). This balance was a “reserve” purportedly against liquidity leaks (not to be confused with loan loss reserves). However, since the funds were tied up, they effectively only acted as a tax on the banks when reserve balances did not pay interest.
Eventually, the Americans followed the lead of other developed countries and effectively abolished reserve requirements. Whether or not people will stop calling settlement balances “reserves” remains to be seen.
Following?
Although I could move on to a completely different topic, I think the next article will focus on the central bank’s operations and/or balance sheet structure.